Premiums will benefit from relief against corporation tax as a business expense but only where the policy is put in place solely to cover a potential loss of profits. Broadly, if the premiums attract tax relief then the policy proceeds are likely to be taxable as a trading receipt.
Corporation tax relief for premiums paid by the business is normally allowed providing the following all apply:
1. Cover is short term or annual (for example, term assurance usually less than five years, rather than whole of life, annual premiums rather than single).
2. The sole relationship is employer/employee (so tax relief might not apply for significant shareholders). Directors are considered to be employees.
3. The sum assured is paid to the employer to cover loss of profits arising from the key person’s absence.
Corporation tax relief will not be available where the policy has a surrender value because a portion of the premiums are directed towards investment rather than solely to cover loss of profits.
Corporation tax relief may not be available on assurance premiums where the life assured is a significant shareholder (generally holding 5 per cent or more of the company’s shares).
This is because the premiums would fail the ‘wholly and exclusively’ test; the policy is put in place partly for the shareholder’s benefit to protect against a fall in share value, rather than solely to allow the business to continue trading in the event of the loss of a key person.
Its important to note that the tax treatment of both premiums and proceeds will be determined by the company’s inspector of taxes and should be confirmed with them at outset.
Debt protection
Banks lending to the business will often require a policy in place to cover the loan in the event of an individual’s illness or death. This is not strictly key person insurance and will not gain corporation tax relief because the policy is put in place for the benefit of the lender, rather than to replace lost profits.
Renewable term assurance is often used for key person cover. Convertible term assurance premiums may not be tax-relievable because they could potentially become partially used for investment purposes. The term of cover can be adjusted, for example to fall in line with the life assured’s expected retirement date.
If the policy pays out, the benefits are generally taxed as a trading receipt in the year of payment and will be subject to corporation tax. A one-off lump sum payment may artificially increase profits for the year.
The policy may provide the option of receiving benefits in instalments over multiple years which would better reflect the profits lost over time due to the loss of the key person, and stagger the corporation tax liability.
Level of cover required
It can be difficult to assess the likely loss to the business and therefore the level of cover required. Common methods of calculating the amount of cover include using a multiple of salary or considering the profits generated by that individual. The time and cost of replacing a key person should also be considered. An excessive level of cover may result in the premium failing to qualify for corporation tax relief and the potential taxation of the sum assured is also a consideration.
Share protection
On the death of a shareholder, generally the remaining shareholders would want to retain control of the company and the deceased shareholder’s family would want the cash value of the shares.
Whole-of-life policies are used to direct the shares to the remaining shareholders and provide the family with a cash lump sum.
The company cannot obtain tax relief on whole-of-life premiums because the policy is not for the purposes of ongoing trade but for the benefit of the individuals and their families. Therefore, the directors will pay the premiums themselves out of their taxed income. The policy proceeds are then usually paid tax-free to the nominated beneficiaries.
A company’s articles of association may restrict how shares can be transferred and provisions about the way they are valued, in the event of a shareholder’s death.
There can be significant difficulties in valuing a shareholding of a private company, particularly following the death or illness of a key person that will have a detrimental effect on trade. The value of the shares and the value of the policy are likely to diverge over time as the business grows and so a company’s protection provisions must be regularly reviewed to ensure they are fit for purpose. An independent valuation is required; it should not be done by the company’s own accountant because they are likely to instinctively favour the remaining directors.
Business Property Relief Partnership holdings and shareholdings in unlisted incorporated companies generally qualify for 100 per cent BPR meaning no tax consequences on the passing of shares to other shareholders or on the sum assured paid to the beneficiaries.
However, a binding requirement for a deceased shareholder’s shares to be sold is a contract and will result in loss of BPR as at the date of death. This is because, on the date of death, the asset will be effectively in the form of cash rather than shares, which would not qualify for BPR.
Cross-option (or double option) agreements are often used to circumvent this issue. If one party exercises their option to buy or sell, the other party is obliged to comply. These arrangements are not binding contracts for sale and thus BPR is still available.
Cross-options will generally have an expiry date to provide greater certainty to the parties involved.
Ill health
Income protection and critical illness cover can protect against ill health while the individual is of working age.
Key person income protection can pay instalments until the assured is able to return to work. Critical illness cover (CIC) provides a lump sum in the event of a specified diagnosis.
Where policies are used to cover ill health, a single option allowing the ill director to sell their shares to the remaining shareholders is preferable. A cross-option may force the ill director to sell their shares where they feel they may be able to return to work. A forced sale may also leave the ill director liable to CGT and bring cash into their IHT estate that might have been fully relievable under BPR.
Difficulties can arise where the ill director is not capable of making a decision. Remaining shareholders may be left with a cash lump sum but no right to purchase the shares.
It may be more appropriate for directors to arrange CIC to cover their personal needs and deal with the business shares under a separate company policy. There is no ‘correct’ answer in this situation and it will depend on the merits of each individual case.
Split trusts
These policies cover both critical illness and death and can be whole-of-life or term assurance. Benefits are paid out on the first event, i.e. they are paid to the assured individual on serious illness, otherwise to the beneficiaries on death.
A potential drawback with split trusts is that, where a claim is made for critical illness but death occurs shortly afterwards, the critical illness benefits paid out are likely to remain in the life assured’s estate for the purposes of IHT – which would probably not have been the case had the benefits been paid out (subject to a suitable trust) on death.
Danny Cox is chartered financial planner and head of financial planning at Hargreaves Lansdown
